Jing-Zhi Huang

Structural models of corporate bond pricing: An empirical analysis

This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986–1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds.

Explaining Credit Spread Changes: New Evidence From Option-Adjusted Bond Indexes

Credit risk is also the subject of this article by Huang and Kong. There are numerous credit risk models in which the relevant stochastic variables for pricing a risky bond are obtained from the term structure of interest rates, and perhaps from firm-level capital structure data. In this article, the authors look at option-adjusted spreads on corporate bond indexes for different credit ratings classes. They find that term structure variables alone are limited in their ability to explain yield spreads, but adding macroeconomic variables, like an index of leading economic indicators, and equity market variables, including the return on the Russell 2000 index and the Fama-French “high minus low” factor, can contribute significant explanatory power, especially for lower rated bonds.

Inflation Risk Premium: Evidence from the TIPS Market

“Inflation-indexed securities would appear to be the most direct source of information about inflation expectations and real interest rates” (Bernanke, 2004). In this paper we study the term structure of real interest rates, expected inflation and inflation risk premia using data on prices of Treasury Inflation Protected Securities (TIPS) over the period 2000-2007. The estimates of the 10-year inflation risk premium are between 11 and 22 basis points for 2000-2007 depending on the proxy used for the expected inflation. Furthermore, we find that the inflation risk premium is time varying and, specifically, negative in the first half (which might be due to either concerns of deflation or low liquidity of the TIPS market), but positive in the second half of the sample. JEL Classification: E31, E43, E44

The Information Content of Basel III Liquidity Risk Measures

We present a comprehensive analysis to calculate the Basel III liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) of U.S. commercial banks using Call Report data over the period 2001–2011, and provide indirect empirical evidence on net cash outflow rates of certain liability categories. In addition, we examine potential links between Basel III liquidity risk measures and bank failures using a model that differentiates between idiosyncratic and systemic liquidity risks. We find that while both the NSFR and the LCR have limited effects on bank failures, the systemic liquidity risk is a major contributor to bank failures in 2009 and 2010. This finding suggests that an effective framework of liquidity risk management needs to target liquidity risk at both the individual level and the system level.

The Inflation Risk Premium:Evidence from the TIPS Market

This article estimates inflation risk premia using data on prices of Treasury Inflation-Protected Securities (TIPS) from 2000 to 2008. The estimation approach is arbitrage-free, largely model-free, and easy to implement. It also distinguishes between TIPS yields and real yields by explicitly taking into account the three-month indexation lag of TIPS in the analysis. In addition, we consider three measures of TIPS liquidity, including one new measure based on TIPS prices only. We estimate the liquidity premium to be around 13 basis points over the full sample but substantially higher in the first subperiod. We find that the inflation risk premium is time-varying and, on average, considerably lower than suggested by various structural models. Depending on the proxy used for expected inflation, the unconditional 10-year inflation risk premium ranges from –9 basis points to 4 basis points over the full sample, and between 1 basis point and 6 basis points over the 2004–2008 subperiod.

The Slope of Credit Spread Curves

One way to test a corporate bond pricing model is to examine its predictions for the shape of credit yield spread curves. However, existing empirical studies along this line are known to be problematic because of not controlling properly for the credit quality of bonds (an exception is Helwege and Turner [1999] who study the slope of credit spread curves for high yield coupon bonds). In this article we examine credit spread curves for both zero-coupon and coupon bonds and for both investment grade and high yield bonds. We find that the term structure of credit spreads is usually upward sloping, regardless of credit quality or coupon.

An Econometric Model of Credit Spreads with Rebalancing, ARCH and Jump Effects

In this paper, we examine the dynamic behavior of credit spreads on corporate bond portfolios. We propose an econometric model of credit spreads that incorporates portfolio rebalancing, the near unit root property of spreads, the autocorrelation in spread changes, the ARCH conditional heteroscedasticity, jumps, and lagged market factors. In particular, our model is the first that takes into account explicitly the impact of rebalancing and yields estimates of the absorbing bounds on credit spreads induced by such rebalancing. We apply our model to nine Merrill Lynch daily series of option-adjusted spreads with ratings from AAA to C for the period January, 1997 through August, 2002. We find no evidence of mean reversion in these credit spread series over our sample period. However, we find ample evidence of both the ARCH effect and jumps in the data especially in the investment-grade credit spread indices. Incorporating jumps into the ARCH type conditional variance results in significant improvements in model diagnostic tests. We also find that while log spread variations depend on both the lagged Russell 2000 index return and lagged changes in the slope of the yield curve, the time-varying jump intensity of log credit spreads is correlated with the lagged stock market volatility. Finally, our results indicate the ARCH-jump specification outperforms the ARCH specification in the out-of-sample, one-step-ahead forecast of credit spreads.

Sentiment and Corporate Bond Valuations Before and After the Onset of the Credit Crisis

Stock market sentiment is an important driver of corporate bond valuations. Using transactions from the Trading and Compliance Engine (TRACE), the authors find that sentiment is negatively related to bond yield spreads, with the impact being stronger after the onset of the recent financial crisis. The negative effect of sentiment on yields is stronger when fundamental risk and liquidity frictions are higher, which points to a direct role of sentiment in the bond market whereby rational bond investors are unable in these high-risk/high-friction scenarios to correct the mispricing generated by other bond investors. The authors also find that the sentiment effect is stronger when the returns to capital structure arbitrage are higher, suggesting that sentiment also spills over to the bond market through the activity of invesinvestors dedicated to correcting relative stock and bond value mispricings within the same firm. They further provide evidence that after the onset of the crisis, sentiment also helps explain the extent to which the corporate bond market and the equity market are integrated.

The Structural Approach to Modeling Credit Risk

In this article we present a survey of recent developments in the structural approach to modeling of credit risk. We first review some models for measuring credit risk based on the structural approach. We then discuss the empirical evidence in the literature on the performance of structural models of credit risk.

Debt Covenants and Cross-Sectional Equity Returns

This paper investigates the impact of debt covenant protection on the cross section of equity returns with a firm-level covenant index and four subindices. We find that firms with weaker covenant protection (lower covenant index levels) earn significantly higher risk-adjusted equity returns than do those firms with greater covenant protection. These results are stronger for covenant indices that are related to investments, subsequent financing, and event risk. The difference between high and low covenant index stocks is more pronounced when agency problems between shareholders and debtholders are more severe, suggesting that the covenant effect arises from an inability to control shareholder risk taking. This paper was accepted by Wei Jiang, finance.